An Expert's Guide To Short Straddle: How To Manage Risk

A short straddle is an options trading strategy that involves buying both a put and a call with the same strike price and expiration date. It's a neutral strategy that has limited risk and limited reward. The risk is limited because the worst-case scenario for the trader is to break even. On the other hand, the potential reward is also limited because there is only one possible outcome: locked in green premium with no possibility of losing more than you paid for both options. In this article, we will look at what short straddle means, how it works, its advantages and disadvantages, best practices to manage risk while trading short straddle, and three strategies you can use to increase your edge as an investor.

What is Short Straddle?

A short straddle is an options trading strategy where you simultaneously buy a put and a call with the same strike price and expiration date. The put and call have the same expiration to avoid the risk of time decay. Let's say you buy a short straddle position on Tesla shares with a strike price of $450. You're betting that the price of the stock will stay between $450 and $550 at the expiration date. If it does, you'll walk away with the full amount of money you spent on the two options. You'll lose your initial investment if the stock closes above $550.

How Does Short Straddle Work?

In a nutshell, you simultaneously buy a put and a call with the same expiration date and strike price. The strike price is the price at which you can buy or sell the underlying asset. The expiration date is the date by which the option buyer has to decide whether to exercise the option. The advantage of buying the put and call together is that it limits your risk to the initial investment. The disadvantage is the cost of buying both is higher than just buying an option.

Advantages of Short Straddle

- Low Risk: In a short straddle position, you have a limited risk because you also have limited potential gains. A short straddle strategy can be extremely profitable when you're correct about the direction of the market but still generates a decent return if you're wrong. For example, if you short-straddle an ETF and the ETF doesn't move, the options expire worthlessly, and you get to keep the full amount of money you invested.

- No Leverage: While most options strategies involve using leverage, short straddle strategies don't. Using leverage is a double-edged sword in options trading because it magnifies gains as well as losses.

- Keeps You in the Game: If you're unsure if a certain stock or ETF is ready to make a move, you can use a short straddle to stay in the game while waiting for the right opportunity.

- No Correlation: Short straddles tend to have a low correlation with the general market, which means that when the market is falling, short straddles tend to do the opposite.

- Diversification: Short straddles can be used to diversify your portfolio because it's a neutral strategy.

- Limited Time: Short straddle positions have a limited period (it ends at the expiration date). This means you don't need to keep an eye on your positions daily. You can keep short straddle positions open for months, even if there is no immediate catalyst for movement.

Disadvantages of Short Straddle

- Risk: The biggest disadvantage of the short straddle strategy is the risk, especially if you don't know the underlying asset well. If you're wrong about the market's direction, you may not make any money. In fact, you may lose all the money that you invested in two options.

- High Initial Investment: While many options strategies don't require a lot of capital, short straddles are an exception. You need to spend a decent amount of money to buy two options at the same strike price.

- Time Decay: While the risk associated with short straddles is high, the rewards are usually low. Why? Because options are a wasting asset, their value tends to decrease over time. If a market doesn't move in your favor, the time decay associated with the options reduces your gains.

- No Leverage: Another disadvantage of short straddles is that they don't provide any leverage.

- No Correlation: Short straddles have a low correlation with the general market, which means that when the market is falling, short straddles tend to do the opposite. This means that short straddles don't help diversify your portfolio.

3 Strategies to Increase Your Edge with Short Straddle

- Buy Out-of-the-money: If you buy an out-of-the-money option, you can increase your chances of success with the short straddle strategy. The closer the option is to expire worthless, the better. If you buy an option out of the money, you have a high probability of making money with little or no downside risk.

- Buy a Long-dated Option: If you buy a long-dated option, you'll have an even higher chance of success. Again, the more time that the option has to expire without movement, the better.

- Buy a Wide Straddle: A wide straddle involves buying options with a wide range of strike prices. This means that your profit potential is higher than with a short straddle. However, it also means that your risk is higher, too.

Risk of early assignment

The options exercised in the country can be done on any day the financial markets are operational. The holder of any short stock option has no say over when they will be needed to complete their side of the obligation. So, the risk of early assignment is always a probability that must be considered when looking to enter positions involving short options. Both the instruments in a short straddle have the risk of early assignment. This activity is usually related to dividends. If the price of the share is above the strike price of that short straddle, the trader must find out if there can be an early assignment. If that is a chance, and the short stock position is not required, then the correct action must be taken before the assignment takes place.

Conclusion

A short straddle is a neutral options trading strategy with low risk and reward. Traders who use this strategy bet the underlying asset will stay between two price points at the expiration date. If they're right, they'll make the amount of money they paid for both the put and call options. If they're wrong, they'll lose nothing more than the amount of money that they spent on the options. Hedging is a strategy used in investing in reducing risk. It can be done by buying or selling different assets, buying or selling different options, or buying or selling different futures. It is important to understand the different types of hedging before investing. This will allow you to make informed decisions and help you to reduce risk when investing your money.